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Monday, November 21, 2011

Today, it looks like the "Super Committee," which was tasked with making a $1.2 trillion reduction in our national debt, will fail. Though a lot of different messages have been coming out about why this group failed (among them, apparently, the startling revelation that John Kerry talks too much), certainly one sticking point has been that conservative members of Congress are uniformly opposed to any sort of repeal of the Bush era tax cuts.

Do Tax Cuts Hurt Business Investment?

This obsession with tax cuts has always struck me as peculiar. The basic argument seems to be centered around the idea that tax cuts on the wealthy and on corporations result in freeing up more money for corporate growth and job creation. But I question this. A couple of months ago, I got into a discussion on a friend's Facebook page on just this topic and made the following comment:

I always wonder ... Who are these job creators who would be hiring, but are afraid they can't afford their taxes? I always hear things like, "Businesses can't afford to hire more people and/or expand their business because of their tax burden" ... except that any sort of business expansion comes off the top, BEFORE TAXES. If you want to expand your business, doing so incurs no tax burden whatsoever, doesn't it?

One person on the thread responded with what seemed to be a reasonable explanation:

Lets say that your profit margin is 10%. You have decided that it will cost you 2% of that profit to hire a new employee with the goal of expanding business. If your tax rates might go up in the next year or two that will reduce your profit margin enough to eat up most or all of the cost of that new hire, you might decide to wait until you either know for sure that your taxes are, in fact, going up, choose to hire anyway, or decide not to go for it. Its most likely the uncertainty that is keeping those folks on the sideline (are the Bush tax cuts expiring? Are they not? etc)

There's an instinctive logic to this argument. If the amount of money that you have goes down, then surely the amount you have to spend on your business is going to drop. Surely, it hurts this reinvestment to increase taxes, right?

Some Tax and Growth Scenarios

This conversation took place a good two months ago, but it's been sticking in my craw since then. Something about the numbers just didn't sit right, so I decided to actually work it out. Let's consider this situation from multiple different scenarios:

Scenario A: 35% corporate tax

This is the current scenario, as outlined by the individual above. The total net profit of the company is 10% of the total revenue the company brings in. Working backward from that, some quick math shows that, at a tax rate of 35%, we get the following as percentages of total revenue:

The final scenario is the one which, according to economic conservatives, would be unlikely to happen. Scenario C is the one they think is very likely - leave taxes alone, and businesses will be motivated to invest and create jobs. If, however, you increase taxes by 3%, then the numbers that follow are so intimidating that businesses would rather stick back in Scenario B than move forward.

Assumption: Constant Revenue

Now, before delving into these numbers too deeply, let's consider the implications of keeping the revenue the same in all these scenarios:

1. That business in scenarios 3 & 4 is re-investing an extra 2% of their revenue back into the business. Presumably, this is being done with a plan to expand their business operations and, in turn, increase their total revenue. Still, it's possible that these plans will take a while to pay off, so it's realistic to assume that they'll have to front this money for a while without seeing benefits from the work.

2. The business in scenarios 2 & 4 exists in a world with a 38% tax rate, so it's possible that the overall effect of this tax rate drags the economy down a bit (as economic conservatives claim) and, in turn, lowers their total revenues or increases non-tax expenses in some unforeseen way. Still, this claim is highly speculative and I don't know a good way to put a number on how the economic impact of 3% taxation would affect this hypothetical company, so I just assumed the total revenue stayed constant.

The Analysis

Back to the actual numbers, then. You'll notice that despite the fact that they've reinvested 2% of their total revenue back into the business, in none of these scenarios does their Net Profit drop by 2%. This is because, as I mentioned in my Facebook quote earlier, businesses operate from a very favorable tax position: they pay their expenses before they pay their taxes. Individuals don't have this option (usually). If I spend 2% of my money on a personal item, I have to pay the full tax on the 2%. This means that for someone in the 10% tax bracket, who has a job where they pay 7% into Medicare & Social Security, each dollar they get comes with a 17% tax on top of it.

An individual spending 2% of their gross income on their needs, therefore, actually has to take 2.17% of the total money they've earned to do it (excluding sales tax). A corporation spending 2% of its gross income on its needs costs a mere 1.3% of the revenue that it's brought in. This is assuming the tax rate stays consistent at 35%, of course. An increase of 3% taxation means that 2% costs the company a whopping 1.7%.

This, incidentally, is why every individual should have their own home-based business in something they're passionate about.

There are a number of ways to consider these numbers, and choosing which one is largely based on your political stance.

Interpretation 1: Tax Increases Cost Money

Scenario B results in less net profit than scenario A and scenario D results in less net profit than scenario C, so a conservative would argue that the increase in taxes causes a drop in the profit earned by the company (and, as a result, by the individual shareholders). This is a perfectly valid interpretation and fits the facts, although it is a very narrow interpretation, completely ignoring any potential benefits from a 3% corporate tax increase.

Interpretation 2: The Tax Incentive

The problem is that conservatives don't just argue that the corporations will lose money, but also that it will be too expensive for them to invest in growth if their taxes increase. This doesn't hold up with these numbers, however. In the above scenario, if the taxes stay at 35% it costs 1.3% to reinvest 2% into their business. If the tax is raised by 3%, however, the drop from 9.54% to 8.3% is 1.24%.

Why does this happen? Because, again, businesses pay taxes based on their after-expense income.

In a sense, lowering taxes actually gives less incentive to growth, because as a percentage, reinvesting in the business doesn't get you as much bang for your buck.

Interpretation 3: The Growth Incentive

Keep in mind that the overall goal we want is to have businesses grow, meaning that either Scenario C or D is preferable to either Scenario A or B. It turns out that getting the 2% is what causes the big penalty to the net profits, not the 3% tax on profits.

Still, the fact is that - taken by itself - the 3% tax increase makes it just a little bit less cost-effective, in absolute dollar terms, to take the risk to grow your business.

But then, the point of raising taxes wasn't to promote growth ... it was to increase tax revenue. The argument that it will instead drive down growth just doesn't seem particularly justified, at least based on this particular example. If the business wants to grow, the 3% increase in taxes just doesn't have much bearing at all.